2023-04-10 11:27:25 ET
Summary
- STRL's home turf is benefitting from elevated IIJA-related funding.
- STRL's cash-compounding qualities are one of its primary strengths.
- EV/EBITDA valuations don’t look expensive given the potential margin improvement on the cards.
- Building solutions face ample concentration issues and the residential market could be weak in H1.
- The risk-reward on the RS charts does not look great, and the current momentum is with the bears.
Company Snapshot
Sterling Infrastructure ( STRL ) is a US-based infrastructure service provider that was previously noted primarily for its expertise in highway projects. The company currently reports under three segments-
- E-Infrastructure Solutions (~57% of group revenue): Provision of large-scale specialty site infrastructure improvement to large, blue-chip clients belonging to industries such as e-commerce, warehousing & distribution, data-center, and energy.
- Transportation Solutions (~31% of group revenue): Services here are primarily rendered to State DOTs (Department of Transportation), airport authorities, water authorities, and regional transit authorities in areas such as heavy highway work, railway infrastructure, etc.
- Building Solutions (~18% of group revenue): This business is predominantly centered in their home state-Texas, where they abet home builders, developers, and contractors from the residential and commercial markets.
What’s Good
Sterling Infrastructure could work as a fine proxy to exploit increased infrastructure fervor related to the $550bn worth Infrastructure Investment and Jobs Act (IIJA) as it has a diversified presence across different infrastructure segments. Even though federal funding has been progressing smoothly with ample contract wins for engineering and construction firms so far, it is believed that projects announced in 2022 are just a fraction of what is yet to come. Crucially, as things stand, most of the funding has been centered around Texas and two other states. You’d be interested to note that Sterling’s home turf is in Texas and all its segments are well-entrenched in the state.
Another noteworthy quality of Sterling Infra is its ever-growing prowess in cash generation which has been instrumental in driving its cash on books to record highs of $181m last year. With such strong levels of internally generated cash flow, STRL is in a very good position to pursue its inorganic ambitions, be it the typical $10-$50m deals, or something more transformational.
Coming back to the cash flow generation, you're talking about a business that since its free cash flow per share increased every single year since FY17 growing at an impressive 6-year CAGR of 44%!
Seeking Alpha
Also note that if you’re getting in now, you’ll be getting a stock with a pretty hefty FCF yield of 15%, almost 300bps higher than its 5-year average yield.
It also helps that e-infrastructure’s share in the overall revenue pie is growing (93% YoY growth last year) as this is an innately high-margin business. Currently, e-infra accounts for the largest share of group operating income at 66%, (51% of sales) and has been very instrumental in driving higher conversion of cash flow. Management believes that going forward, the higher data center activity will likely ensure that e-infra remains the fastest-growing division.
If e-infra continues to gain traction in the overall mix (management thinks it could generate low double-digit growth next year), investors can be reasonably certain that group EBITDA margins could continue to trend up from the 11.84% levels seen last year. Indeed, at least consensus believes this will happen with an expected EBITDA margin improvement of 33bps next year, followed by an even better performance in FY24 (40bps improvement to levels of 12.57%).
When you consider the degree of potential operational margin improvement going forward, you may think a stock like this may trade at a premium to its long-term average. However, taking the FY23 EBITDA estimates ($231m) into consideration, STRL’s forward EV/EBITDA multiple only works out to 5.67x, marginally lower than the 5-year EV/EBITDA average of 5.75x .
Risks
Certain pockets within Sterling's Building Solutions segment are expected to remain weak for the foreseeable future. For instance, the residential markets of Dallas and Phoenix have witnessed slowdowns and will likely remain weak at least through H1-23.
Investors should also consider that Sterling deals with customer concentration issues across most of its segments but it is most pronounced in the Building Solutions terrain where four customers accounted for 60% of the total segment revenue in FY22
Closing Thoughts
On the charts, there are a couple of things to highlight. The chart below sheds some perspective on the price imprints of STRL on a weekly basis. We can see that since 2020, STRL had been trending up in the shape of a consistent ascending channel but by the end of January it had spiked past the upper boundary of its channel and looked quite overextended all through February.
The stock was not able to build any sustained momentum beyond the $40 level and has since seen a drastic pullback, even dropping below the upper boundary of the channel quite recently. Even though the stock is now trading within its old channel range, I think investors would be better served waiting for a price point that represents better risk-reward within the old channel (you ideally want to get in at a zone closer to the lower boundary of the channel). Besides if you look at the lower time frame chart, the dreaded lower-low/lower-high conditions of a downtrend are still very much in play. Investors should wait to see some bottom formation before jumping in.
Besides, investors also need to consider that relative to other peers from the US infrastructure space, the Sterling Infrastructure stock still looks quite overbought. Currently, the relative strength ratio of STRL and the ETF -IFRA is around 30% higher than the mid-point of the long-term range. This may prompt some rotation out of STRL in favor of other options that offer better risk/reward.
For further details see:
Sterling Infrastructure- Wait For The Downtrend To Abate